Academic journal article Atlantic Economic Journal

Nominal versus Real Wage Rigidity in a Monopoly Union: A Synthesis

Academic journal article Atlantic Economic Journal

Nominal versus Real Wage Rigidity in a Monopoly Union: A Synthesis

Article excerpt

Ching-Chong Lai (*) Juin-Jen Chang (**)


In his recent paper, Benassy [1995, p. 635] claimed that, "Whether rational wage setting by explicitly maximizing agents leads to real or nominal rigidities ... is evidently an issue of utmost importance to explain the causes of potential market imbalances and study corrective policies." Based on a monopoly union model in which wages are set by a utility maximizing union, this paper attempts to provide a synthesis of the possible situations generating either real or nominal wage rigidity. (1)

Among the literature on monopoly union models, Oswald [1985] finds that whenever the elasticity of labor demand is constant, a rise in the product price is impotent in changing the union's desired wage. Hence nominal wage rigidity will prevail. On the other hand, Holmlund, Lofgren, and Engstrom [1989] claim that given the constant elasticity of labor demand, the union wage rises equiproportionately with the increase in the domestic price if unemployment benefits are adjusted with an equal percentage change in the domestic price. So real wage rigidity will be present. However, there are two fundamentally different assumptions in the above cited literature with respect to setting up the theoretical frameworks. The first is the degree of money illusion. Oswald [1985] implicitly assumes that union members are subject to complete money illusion, while Holmlund, Lofgren, and Engstrom [1989] assume that union members are free of any kind of money illusion. The second is the rule of unemployment benefit indexation. O swald [1985] treats nominal unemployment benefits to be sticky, while in Holmlund, Lofgren, and Engstrom [1989] nominal unemployment benefits are assumed to be fully indexed to the domestic price.

Money illusion is a critical element in the debate over policy effectiveness. It is widely accepted that in the long run people are free of money illusion, while in the short run the public are subject to some degree of money illusion. (2) In addition, unemployment benefits now are regarded as one kind of social security policy. However, in practice the government adopts alternative ways to undertake unemployment benefits systems. On the one hand, to guarantee an equitable distribution of income, unemployment benefits are proposed to be indexed to the employee's wage. On the other hand, to escape from the loss arising from the erosion of inflation, unemployment benefits are proposed to be indexed to the domestic price. (3)

In order to reflect the diverse empirical findings concerning the extent of money illusion and the form of unemployment benefits, this paper attempts to construct a generalized model in which alternative degrees of money illusion and various indexation schemes of unemployment benefits are incorporated into the picture. By doing so, we can clearly shed light on whether the determination of union-set wages and employment is related to the extent of money illusion and the form of unemployment benefits.

The rest of the paper is arranged as follows. A description of the analytical framework is presented in the second section. The third section identifies possible outcomes of union-set wages and employment following an increased domestic price in the presence of complete money illusion, while the fourth section addresses the consequence of raising the domestic price in the absence of money illusion. Finally, the fifth section offers some concluding remarks.

The Theoretical Model

This section constructs a monopoly union model which includes both elements of money illusion of the union member and unemployment benefit indexation. Define y and [pounds] as the domestic output and laboi~ employed, respectively. The firm then has a short-run production function f:

y = f(l); f' > 0, f" < 0 (1)

The objective of the representative firm is to maximize the following profit function [pi]:

[pi] = py - wl, (2)

where p denotes the domestic price and w denotes the nominal wage. …

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